Italy downgrade triggers inflation bond sell-off
Prices on Italian government inflation-linked debt dipped before the weekend as a two-notch downgrade by Moody’s Investors Service kicked the sovereign out of a key Barclays index – and dealers expect a new issue of inflation bonds, planned for the end of this month, to be cancelled.
Under the rules of the Barclays inflation-linked bond index, countries are ejected when they are rated lower than A3 or A- by two of the big three rating agencies. Standard & Poor’s already rated Italy below this threshold and Moody’s joined it, cutting the country’s rating from A3 to Baa2 after markets closed on July 12. At the end of last year, Italy’s linkers made up 28.4% of the index, and its downgrade last week prompted a sell-off of Italian bonds by investors that track the index.
“On Friday morning, Italian linkers were down around 50 basis points on the corresponding nominals, which is a significant market event,” says Kari Hallgrimsson, head of European inflation trading at JP Morgan in London.
The market had been preparing for the impact since the turn of the year. In January, Risk reported that dealers were lobbying the European Central Bank (ECB) to expand its securities markets programme – through which the ECB buys the bonds of under-pressure eurozone governments – to include linkers. Dealers argued the policy of buying only nominal bonds would distort breakeven rates – the difference between the real yield on an inflation-linked bond and the yield on a nominal bond, which is used as a measure of inflation expectations.
Even without ECB intervention, though, the market had adjusted for the possibility of Italy’s expulsion, with many fund managers switching to other indexes, says Hallgrimsson.
“The potential for another downgrade has been there for quite some time, so its impact has been limited somewhat. I would estimate that around 40%-50% of bond managers who track this index have shifted over to other indexes that have less strict criteria over the past six months or so,” he says.
There are alternative sovereign inflation indexes on offer from JP Morgan, Citi and Barclays itself, which runs a second index that it inherited when it acquired a chunk of Lehman Brothers in 2008. “The Barclays index is the only one from which Italian linkers have been excluded because of this downgrade. It’s a real outlier, and has clearly lost some market share over the past six months because of this. All the other nominal and linker benchmarks have less severe credit rules,” says a dealer at a large European firm.
As well as shifting towards these other indexes, market participants have showed increased interest in inflation-linked debt from core eurozone sovereigns. “The French and German linkers performed well in response because people were reallocating funds from Italian linkers towards these instruments. For example, the price for German 10-year linkers moved up by 20bp over Friday and today,” says Stephane Salas, global head of inflation trading at Deutsche Bank in London, speaking on July 16 – the second trading day after the Moody’s downgrade.
According to Salas, not all the action was one-way. “After that first pricing shock in the morning, Italian linkers settled at around 30bp below corresponding nominal issuance as some people started buying them. Italian real-money funds have been taking advantage of the relative cheapness of Italian linkers and picking them up throughout this period, especially the shorter-term maturities.”
Fund managers also have some breathing space before exiting their Italian linker positions, as the Barclays index does not formally kick them out until the end of July. This leaves opportunities for prospective buyers. “I wouldn’t be surprised if you have some of the more active bond managers buying up the linkers over the next week or so. You want to buy these bonds now when they are cheap, because they are likely to outperform nominals on a breakeven basis after the index has rebalanced at the end of the month,” says Salas.
To help keep the linker market alive, dealers suggest the Italian treasury could initiate switch auctions in the near future, where market participants can sell linkers back to the issuer in return for nominal bonds. But the country may also be forced to cancel or postpone further linker auctions. “There should be a linker auction at the end of this month, but I don’t think that is going to go ahead because there is already enough supply in the market thanks to this downgrade and the subsequent sell-off,” says the dealer at a large European firm. “But in the long run, I don’t think linker issuance will dry up completely.”
This article was first published on Risk